Tuesday, 16 April 2013

In my previous blog post I outlined some of my criticisms of the neoliberal stance against Big Government, and in particular the spurious arguments that are generally advanced in support of the concept of low taxes and the small state; arguments such as the Rahn curve. This is not to say that the Rahn curve is wrong per se. I doubt than many would argue that there should be no upper limit on government spending, or that politicians should always aim to make the public sector as large as possible. The real problems with the Rahn curve are twofold.

Firstly, it implies that the only variable that matters in determining economic growth is the quantity of government spending, and not what the money is spent on, or other factors within the economy such as levels of investment (public and private), education, consumer demand or inequality.

Secondly, it implies that there exists a single unique value for the ratio of government spending to GDP that is optimal for all countries irrespective of their size, their stage of economic development or their range of economic diversity.

For example, there are many developing countries with smaller governments and much larger growth rates than the UK: China, Brazil, India for example. But even if all developing countries with smaller governments than the UK have larger growth rates, that does not mean the UK would increase its own growth rate by following suit and reducing the size of the State. These countries have higher growth-rates than the UK because they are playing catch-up. They don't have to "re-invent the wheel" because other countries have already done that for them. Their growth is not constrained by the limited demand of their own consumers because they can piggyback on the higher spending capacity of consumers in more developed countries. And their governments are small because the disposable income of their citizens is small and so their tax base is small. Therefore the economies of these countries contain no lessons from which we in the UK can learn.

Instead much of the analysis tends to centre on comparisons between countries with advanced economies, particularly those in the OECD. Yet even here there is much subjectivity in the comparative analysis.

For example, last year Martin Wolf of the Financial Times analysed the growth rates of the 18 most advanced OECD countries over the 22 year period from 1989 to 2011 and published them on his blog. The 16 OECD countries he ignored were: Chile, Czech Republic, Estonia, Greece, Hungary, Iceland, Israel, South Korea, Luxembourg, Mexico, Norway, Poland, Portugal, Slovak Republic, Slovenia and Turkey.

The results (shown above) indicate that there is very little evidence that low tax economies yield higher growth rates. Martin Wolf's interpretation of the data was:

The first conclusion is that there is no relation between the share of government revenue and the rate of growth of real output per head (that is, productivity) over the 1989-2011 period. The “regression line” is flat.

I disagree. If you discard the data points for Ireland and Spain for the reason that their growth over the period was artificially inflated by transfers from wealthier EU nations (Martin Wolf also discounts the Irish datum as being an "outlier"); and also those of Australia and Canada because they atypically have economies based on mining and agriculture rather than industry, banking and services (so their growth is not endogenous but is inflated by rises in commodity prices driven primarily by growth in China); then the data actually points to a positive correlation between Big Government and higher growth. The regression line through the remaining data points is linear and has a distinct upward slope. In fact the rise in growth rate is about one percentage point for every 28% of GDP spent by government. Not bad! Not bad at all in fact!

Of course there are many other studies by right-wing economists and think tanks that claim to prove the opposite by selectively using different baskets of countries (often ones with wildly dissimilar economies and questionable political systems) or dubious statistical averages. The approach taken here by Ryan Bourne and Thomas Oechsle at the right-wing Tory/Thatcherite think tank, the Centre for Policy Studies (CPS) is a case in point and one that I find particularly dubious for reasons that I might discuss in a future blog post.

One way to avoid the complication of comparing different countries is to stick to the same country but then compare its performance under different macroeconomic conditions. The history of economic growth in both the UK and the USA over the last 150 years is a good example. Over this period both countries experienced periods of small government (before 1929) and large government (after 1950). The neoliberals would have you believe that the earlier period, when government was small, was a period of dynamic and rapid growth, with the animal spirits of the entrepreneur freed from the later suffocating bureaucracy of the State. What rubbish!

The graph above illustrates the growth in real GDP per capita in the UK from 1850 to the year 2000 (green curve) together with the size of government (black curve). I have highlighted two distinct regions. The blue region is the period of small government where government spending was generally less than 15% of GDP (with a slightly higher blip during the 2nd Boer War). The pink region is the period of Big Government where government spending was generally above 35% of GDP. The period from 1915 to 1950 has been discarded from the analysis because the economy over this time period was dominated by war spending for the First and Second World Wars. Yet the contrast in GDP growth between the blue and pink periods is stark.

Firstly, GDP growth was more unstable in the blue period than it was in the more recent pink period. There were more recessions and those recessions were deeper. The twenty year rolling average of GDP growth (as indicated by the red curve) also shows two distinct patterns of behaviour. This data is shown again on the graph below for greater clarity.

Before 1940 the twenty year rolling average of GDP growth never rose above 1.3%. After 1950 it rarely fell below 1.5%. The average growth rate over the 65-year long blue period 1850-1915 was only 0.94% per annum. For the post-war pink period of 1950-2000 it was more than 2.2% per annum. These are striking differences!

And yet they are not just confined to UK economic performance. Exactly the same trends are to be seen in the economic data of the USA over the same periods.

When one looks at the economic data of the USA for the 25 years immediately prior to the 1929 crash one sees that US government spending averaged less than 10% of GDP. For the 25 years before that the average was even lower at barely 3% of GDP. In contrast, over the period 1950 to 2000 the average was closer to 35% of GDP.

For the period 1879-1929 real GDP was 5.5 times larger in 1929 than it was fifty years earlier. That equates to an average annualized growth of 3.47%. Yet for the fifty years after 1950 the factor was 5.6 and so the growth was actually slightly higher at 3.50%pa. However this neglects the effects of population growth.

Between 1880 and 1930 the US population grew by 150% whereas from 1950 to 2000 it only grew by 86%. So the annualized growth rates in real GDP per capita for the two periods are actually 1.6% and 2.2% respectively. Once again that is a big difference, particularly when continued over fifty years, although the difference is not as stark as in the UK. This difference over time can be seen in the plot of the 20-year rolling average of GDP growth in the graph below.

However the benefits of higher public spending don’t end there. They are also seen in the volatility of the growth rate and the frequency and severity of the ensuing recessions, just as in the UK case. The striking thing about the GDP growth rate over the period 1879-1929 is its extreme volatility. One year growth could be over 10% and a couple of years later GDP is contracting by just as much. This happened repeatedly over that period. As a result the average growth rate was 3.6% but the standard deviation in this value was even greater at 5.2%.

Contrast that with the second half of the twentieth century where the average growth rate was 3.5% but the standard deviation was actually much smaller at 2.3%. Not only that but this period also experienced recessions that were mild by historical standards with contractions in GDP of typically only 1%-2% each time. The period 1879-1929 on the other hand was blighted by repeated recessions where GDP contracted by 5%-10% or more.

What this demonstrates is the stabilizing effect of high government spending (plus of course the added benefits of a Federal Reserve Bank and deposit insurance instead of a system of free banking which existed for most of the 19th Century). It is easy to see why. If government spending is high and generally fixed, then the capacity for the economy to contract during a recession is reduced. So recessions are less severe, less capital investment is lost due to business failures and so when the recovery begins less new capital investment is needed to replace what was lost in the recession. Thus the economy functions more efficiently with higher overall growth rates.

Moreover, even in boom periods Big Government aids growth because it provides the private sector with guaranteed markets. That improves business confidence and therefore raises long-term investment. Not only that, but Big Government also increases the level of redistribution within the economy, thereby reducing inequality and raising aggregate demand, which also boosts investment confidence and growth.

So for those still hankering after small government I suppose the BIG question is this. Which type of economy do you really want to live in?

(i) An economy with more government that offers better public services, higher growth, fewer recessions, greater economic stability and security, less inequality and few if any depressions?

Or:

(ii) An economy with inadequate small government that can only offer poor public services, low growth, more recessions, greater economic instability with little long-term security, more inequality and regular massive depressions?

Sunday, 14 April 2013

Which is better for the economy: a large public sector or a small one?

This is a debate that has continued for decades but is now even more pertinent given the current government's zealous attack on public spending. For while "Slasher" Osborne and his colleagues may continue to claim publicly that their spending cuts are driven by a need to reduce the deficit, the reality is that for many in the coalition this course of action is driven more by ideology than economic reason. They are cutting the size of government because they want too, not because they believe they have to.

For many Thatcherites, neoliberals and old-fashioned Gladstonian Liberals, it is not just about the size of the current budget deficit, or even about the current budget deficit at all. It is about implementing measures that they believe will unleash a tsunami of entrepreneurial dynamism. In fact in both the Conservative Party and in the Liberal Democrats there exists a dominant strand of economic ideology that sees the move towards a small state as a necessary prerequisite for delivering higher levels of economic growth. Of course it is just a coincidence that reducing the size of the state necessarily involves reducing taxes, thereby allowing the rich to retain an even greater proportion of their wealth and income.

At the heart of this debate is the Rahn curve. Like its paramour the Laffer curve which argues that there is an optimal tax rate that maximizes government tax revenues and is therefore used by neoliberals to justify tax cuts for the rich, the Rahn curve claims a similar relation between GDP growth and the size of the public sector. But there are other supposed justifications for a smaller state that are regularly wheeled out by the neoliberal Right. One is the concept of "crowding out" (the squeezing of supply to the private sector by excessive government demand), while the other comes from the various quotes of eminent historical economists (including some seen as being more on the left like John Maynard Keynes and Hyman Minsky) that "in their opinion optimal government spending should be less than 25%".

Of course in the case of eminent opinion context is everything. Keynes may have believed that an economy with 25% of GDP under the control of the State was bordering on excessive, but at the time there was no NHS, and manufacturing, mining and agriculture accounted for over 50% of GDP. Now that these sectors account for less than 20% of GDP can we really cling to the same old certainties or prejudices? Of course not!

A more realistic analysis would be to recognize that the size of the state is inextricably linked to the overall size of the services sector of which it is a major part. Thus as the relative size of production in the economy decreases, the size of services must increase and with it also the size of the State. Not only that, but as the means of production is concentrated into the hands of fewer and fewer workers, so the importance of the State will increase as a necessary means of redistributing the earnings from that production amongst the wider populace. Without it inequality would be greater, and as we are finding now, recessions would be deeper and more frequent.

In the case of the Rahn curve the justification is based on a logic that is derived from the Laffer curve. Yet there is a fundamental difference between the two curves when it comes to the veracity of the theory that underpins their underlying reasoning.

In the case of taxation and thus the Laffer curve, any level or rate of tax yields positive revenues for the government. But if the tax rate is zero, then the revenues collected must clearly be zero. However, if the tax rate is 100% then the revenues collected are also likely to be close to zero as there is no incentive for anyone to work, at least that is the theory (see below for a counter-argument). Thus in the case of the Laffer curve, the revenue curve must be zero when the tax rate is at either 0% or 100% and as the tax revenue must always be positive, the curve must be positive at all points in between. Therefore the curve must have a maximum somewhere in this region. The question that is continually being debated is, where exactly is that maximum? While the neoliberal Right claim it to be as low as possible (20% or less), there is a growing body of evidence to suggest it is much higher and may even be as high as 70%.

The proponents of the Rahn curve try to make an identical argument for GDP growth. Unfortunately their logic is flawed. They try to claim that when there is no government (i.e. government spending is zero), growth must be zero, but there is no reason why this should be true. If as the neoliberals claim, it is the private sector and only the private sector that can deliver economic growth, then they cannot at the same time demand a residual of government spending to make it happen. All that is required for a functioning capitalist economy is a well-defined currency and the rule of law, not government spending.

They also try to claim that when there is no private sector (i.e. government spending is 100% of GDP) growth must be zero again, but there is no reason why this should be true either. Even communist countries can have positive growth rates even if they are generally much lower.

Nor is it the case that growth rates must always be positive for all intermediate sizes of government between the two limits described above. Unlike tax revenues, GDP growth is not restricted to positive quantities.

Thus the Rahn curve is fundamentally flawed, but in truth so is the Laffer curve. As hinted at above, the upper tax limit of 100% will not discourage all work as the neoliberals claim. In practice most people will continue to work even when all their income is taken in tax as they know that the taxes they pay must be returned to them in the form of services and transfer payments, and thus the more they work the more that will be returned. So while a "nationalization of income" will reduce incentives to work harder, it will not completely remove them. Somewhat counter-intuitively, a tax rate of 100% is more likely to kill growth rather than government tax revenues as it removes the incentive for each individual to work harder than his neighbour.

Of course the attempts to intellectually justify the drive for a smaller state do not come purely from Rahn curve analysis. There are other macroeconomic justifications, the primary one being the concept of "crowding out".

The argument is that if the State hogs too much of the nation's resources, then this increases the demand for those resources and so increases their price. This then puts additional costs on the private sector which leads to reductions in growth. And the two resources for which the State has the greatest appetite are labour and capital.

Thus if the State employs too many people, or too many of the most skilled people, then the cost of labour should increase. But if this happens we should see evidence of it in excessive growth in wages and subsequently in inflation and high interest rates. Yet for most of the past twenty years we have seen neither.

Similarly, if the State absorbs too much capital through borrowing or taxing, the effects would be seen in the growing cost of borrowing for business. Again the last twenty years show little evidence of this. It is therefore difficult to justify any claim that crowding out has impeded growth over the last few decades.

So much for the theory behind the Rahn curve and the principle of crowding out. As is we have seen, the curve itself has no mathematical integrity, while the economic data from the last two decades provides no substance to the claim that the State has been too big, or that it has had a detrimental impact on other economic indicators like wages, inflation and interest rates. But what about the comparative evidence with other similar economies, or for economies with different levels of government spending?

In my next post I will show that contrary to the claims of the neoliberal Right, both the USA and the UK have experienced higher growth-rates in the post-war period where their government spending exceeded 25% than they did in earlier periods where government spending was much less than 25%. Not only that, but the increase in government size has contributed to greater economic stability and fewer recessions. In short: Big Govt. = Higher Growth!